Fooled by Randomness (30 page)

Another way to see the beastly aspect of schedules and rigid projections is to think in limit situations. Would you like to know with great precision the date of your death? Would you like to know who committed the crime before the beginning of the movie? Actually, wouldn’t it be better if the length of movies were kept a secret?

The Scrambling of Messages

Besides its effect on well-being, uncertainty presents tangible informational benefits, particularly with the scrambling of potentially damaging, and self-fulfilling, messages. Consider a currency pegged by a central bank to a fixed rate. The bank’s official policy is to use its reserves to support it by buying and selling its currency in the open market, a procedure called
intervention.
But should the currency rate drop a tiny bit, people will immediately get the message that the intervention failed to support the currency and that the devaluation is coming. A pegged currency is not supposed to fluctuate; the slightest downward fluctuation is meant to be a harbinger of bad news! The rush to sell would cause a self-feeding frenzy leading to certain devaluation.

Now consider an environment where the central bank allows some noise around the official band. It does not promise a fixed rate, but one that can fluctuate a bit before the bank starts intervening. A small drop would not be considered to bear much information. The existence of noise leads us to avoid reading too much into variations.
Fluctuat nec mergitur
(it fluctuates but does not sink).

This point has applications in evolutionary biology, evolutionary game theory, and conflict situations. A mild degree of unpredictability in your behavior can help you to protect yourself in situations of conflict. Say you always have the same threshold of reactions. You take a set level of abuse, say seventeen insulting remarks per week, before getting into a rage and punching the eighteenth offender in the nose. Such predictability will allow people to take advantage of you up to that well-known trigger point and stop there. But if you randomize your trigger point, sometimes overreacting at the slightest joke, people will not know in advance how far they can push you. The same applies to governments in conflicts: They need to convince their adversaries that they are crazy enough to sometimes overreact to a small peccadillo. Even the magnitude of their reaction should be hard to foretell. Unpredictability is a strong deterrent.

THIRD THOUGHT: STANDING ON ONE LEG

I have been periodically challenged to compress all this business of randomness into a few sentences, so even an MBA can understand it (surprisingly, MBAs, in spite of the insults, represent a significant portion of my readership, simply because they think that my ideas apply to other MBAs and not to them).

This brings to mind Rabbi Hillel’s story, when he was asked by someone particularly lazy if Hillel could teach him the Torah while the student was standing on one leg. Rabbi Hillel’s genius is that he did not
summarize;
instead, he provided the core generator of the idea, the axiomatic framework, which I paraphrase as follows:
Don’t do to others what you don’t want them to do to you; the rest is just commentary.

It took me an entire lifetime to find out what my generator is. It is:
We favor the visible, the embedded, the personal, the narrated, and the tangible; we scorn the abstract.
Everything good (aesthetics, ethics) and wrong (Fooled by Randomness) with us seems to flow from it.

ACKNOWLEDGMENTS FOR THE FIRST EDITION

First, I would like to thank friends who can be considered rightful coauthors. I am grateful to New York intellectual and expert in randomness Stan Jonas (I do not know any other designation that would do him justice) for half a lifetime of conversations into all subjects bordering on probability with the animation and the zeal of the neophyte. I thank my probabilist friend Don Geman (husband of Helyette Geman, my thesis director) for his enthusiastic support for my book; he also made me realize that probabilists are born, not made—many mathematicians are capable of computing, but not understanding, probability (they are no better than the general population in exerting probabilistic judgments). The real book started with an all-night conversation with my erudite friend Jamil Baz during the summer of 1987, as he discussed the formation of “new” and “old” money among families. I was then a budding trader and he scorned the arrogant Salomon Brothers traders who surrounded him (he was proved right). He instilled in me the voracious introspection about my performance in life and really gave me the idea for this book. Both of us ended up getting doctorates later in life, on an almost identical subject matter. I have also dragged many people on (very long) walks in New York, London, or Paris, discussing some parts of this book, such as the late Jimmy Powers, who helped nurture my trading early on, and who kept repeating “anyone can buy and sell,” or my encyclopedic friend David Pastel, equally at ease with literature, mathematics, and Semitic languages. I have also engaged my lucid Popperian colleague Jonathan Waxman in numerous conversations on the integration of Karl Popper’s ideas into our life as traders.

Second, I have been lucky to meet Myles Thompson and David Wilson, when they both were at J. Wiley & Sons. Myles understood that books need not be written to satisfy a predefined labeled audience, but that a book will find its own unique set of readers—thus giving more credit to the reader than the off-the-rack publisher. As to David, he believed enough in the book to push me to take it into its natural course, free of all labels and taxonomies. David saw me the way I view myself: someone who has a passion for probability and randomness, who is obsessed with literature but happens to be a trader, rather than a generic “expert.” He also saved my idiosyncratic style from the dulling of the editing process (for all its faults, the style is mine). Finally, Mina Samuels proved to be the greatest conceivable editor: immensely intuitive, cultured, aesthetically concerned, yet nonintrusive.

Many friends have fed me with ideas during conversations, ideas that found their way into the text. I can mention the usual suspects, all of them prime conversationalists: Cynthia Shelton Taleb, Helyette Geman, Marie-Christine Riachi, Paul Wilmott, Shaiy Pilpel, David DeRosa, Eric Briys, Sid Kahn, Jim Gatheral, Bernard Oppetit, Cyrus Pirasteh, Martin Mayer, Bruno Dupire, Raphael Douady, Marco Avellaneda, Didier Javice, Neil Chriss, and Philippe Asseily.

Some of these chapters were composed and discussed as part of the “Odeon Circle,” as my friends and I met with a varying degree of regularity (on Wednesdays at 10 p.m. after my Courant class) at the bar of the restaurant Odeon in Tribeca. Genius loci (“the spirit of the place”) and outstanding Odeon staff member Tarek Khelifi made sure that we were well taken care of and enforced our assiduity by making me feel guilty on no-shows, thus helping greatly with the elaboration of the book. We owe him a lot.

I must also acknowledge the people who read the MS, diligently helped with the errors, or contributed to the elaboration of the book with useful comments: Inge Ivchenko, Danny Tosto, Manos Vourkoutiotis, Stan Metelits, Jack Rabinowitz, Silverio Foresi, Achilles Venetoulias, and Nicholas Stephanou. Erik Stettler was invaluable in his role as a shadow copy editor. All mistakes are mine.

Finally, many versions of this book sat on the Web, yielding sporadic (and random) bursts of letters of encouragement, corrections, and valuable questions, which made me weave answers into the text. Many chapters of this book came in response to readers’ questions. Francesco Corielli from Bocconi alerted me on the biases in the dissemination of scientific results.

This book was written and finished after I founded Empirica, my intellectual home, “Camp Empirica,” in the woods in the back country of Greenwich, Connecticut, which I designed to fit my taste and feel like a hobby: a combination of an applied probability research laboratory, athletic summer camp, and, not least, a trading operation (I had experienced one of my best professional years while writing these lines). I thank all the like-minded people who helped fuel the stimulating atmosphere there: Pallop Angsupun, Danny Tosto, Peter Halle, Mark Spitznagel, Yuzhao Zhang, and Cyril de Lambilly as well as the members of Paloma Partners such as Tom Witz, who challenged our wisdom on a daily basis, and Donald Sussman, who supplied me with his penetrating judgment.

A TRIP TO THE LIBRARY

Notes and Reading Recommendations

NOTES

I confess that, as a practitioner of randomness, I focused primarily on the defects of my
own
thinking (and that of a few people I’ve observed or tracked through time). I also intended the book to be playful, which is not very compatible with referencing every idea to some scientific paper to give it a degree of respectability. I take the liberty in this section to finesse a few points and to provide select references (of the “further reading” variety)—but references linked to matters that I directly experienced. I repeat that this is a personal essay, not a treatise.

                           On completion of this compilation I discovered the predominance of matters relating to human nature (mostly empirical psychology) over things mathematical. Sign of the times: I am convinced that the next edition, hopefully two years from now, will have plenty of references and notes in neurobiology and neuroeconomics.

PREFACE

Hindsight bias:
a.k.a Monday morning quarterback. See Fischhoff (1982).

Clinical knowledge:
The problem of clinicians not knowing what they do not know, and not quite figuring it out. See Meehl (1954) for the seminal introduction. “It is clear that the dogmatic, complacent assertion sometimes heard from clinicians that ‘naturally’ clinical prediction, being based on ‘real understanding’ is superior, is simply not justified by the facts to date.” In his testing, in all but one case, predictions made by actuarial means were equal to or better than clinical methods. Even worse: In a later paper, he changed his mind about that one exception. Since Meehl’s work there has been a long tradition of examination of expert opinions, confirming the same results. This problem applies to about every profession—particularly journalists and economists. We will discuss in further notes the associated problem of self-knowledge.

Montaigne vs Descartes:
I thank the artificial intelligence researcher and omnivorous reader Peter McBurney for bringing to my attention the discussion in Toulmin (1990). On that I have to make the sad remark that Descartes was originally a skeptic (as attested by his demon thought experiment) but the so-called Cartesian mind corresponds to someone with an appetite for certainties. Descartes’ idea in its original form is that there are very few certainties outside of narrowly defined deductive statements, not that everything we think about needs to be deductive.

Affirming the consequent:
The logical fallacy is generally presented as follows.

If p then q

q

Therefore, p

(All people in the Smith family are tall; he is tall therefore he belongs to the Smith family).

                           The track record of the general population in correctly making such inference is exceedingly poor. Although it is not customary to quote textbooks, I refer the reader to the excellent Eysenck and Keane (2000) for a list of the research papers on the different difficulties—up to 70% of the population can make such a mistake!

The millionaire mind:
Stanley (2000). He also figured out (correctly) that the rich were “risk takers” and inferred (incorrectly) that risk taking made one rich. Had he examined the population of failed entrepreneurs he would have also inferred (correctly) that the failed entrepreneurs too were “risk takers.”

Journalists are “practical”:
I heard at least four times the word
practical
on the part of journalists trying to justify their simplification. The television show that wanted me to present three stock recommendations wanted something “practical,” not theories.

PROLOGUE

Mathematics conflicts with probability:
One is about certainties, the other about the exact opposite. This explains the disrespect held by pure mathematicians for the subject of probability for a long time—and the difficulty in integrating the two. It is not until recently that it was termed “the logic of science”—the title of the posthumous Jaynes (2003). Interestingly, this book is also perhaps the most complete account of the mathematics of the subject—he manages to use probability as an expansion of conventional logic.

The prominent mathematician David Mumford, a Fields medalist, repents for his former scorn for probability. He writes in
The Dawning of the Age of Stochasticity
(Mumford, 1999): “For over two millennia, Aristotle’s logic has ruled over the thinking of Western intellectuals. All precise theories, all scientific models, even models of the process of thinking itself, have in principle conformed to the straight-jacket of logic. But from its shady beginnings devising gambling strategies and counting corpses in medieval London, probability theory and statistical inference now emerge as better foundations for scientific models, especially those of the process of thinking and as essential ingredients of theoretical mathematics, even the foundations of mathematics itself. We propose that this sea change in our perspective will affect virtually all of mathematics in the next century.”

Courage or foolishness:
For an examination of that notion of “courage” and “guts,” see Kahneman and Lovallo (1993). See also a discussion in Hilton (2003). I drew the idea from Daniel Kahneman’s presentation in Rome in April 2003 (Kahneman, 2003).

Cognitive errors in forecasting:
Tversky and Kahneman (1971), Tversky and Kahneman (1982), and Lichtenstein, Fischhoff and Phillips (1977).

Utopian/tragic:
The essayist and prominent (scientific) intellectual Steven Pinker popularized the distinction (originally attributable to the political scholar Thomas Sowell). See Sowell (1987), Pinker (2002). Actually, the distinction is not so clear. Some people actually believe, for instance, that Milton Friedman is a utopist in the sense that all ills come from governments and that getting rid of government would be a great panacea.

Fallibility and infallibilism:
Peirce (in a prospectus for a never written book), writes, “Nothing can be more completely contrary to a philosophy, the fruit of a scientific life, than infallibilism, whether arrayed in the old ecclesiastical trappings, or under its recent ‘scientific’ disguise.” (Brent, 1993). For a brief and very readable acquaintance to the works of Peirce, Menand (2001). It draws on his sole biography, Brent (1993).

CHAPTER 1

Relative compared to absolute position:
See Kahneman, Knetsch and Thaler (1986). Robert Frank is an interesting researcher who spent part of his career thinking about the problem of status, rank, and relative income: See Frank (1985), and the very readable Frank (1999). The latter includes discussions on the interesting proposer/responder problem where people forego windfall profits in order to deprive others of a larger share. One person proposes to the other a share of, say, $100. She can accept or refuse. If she refuses, both get nothing.

Even more vicious results have been shown by researchers who studied how much people would
pay
to lower other people’s income: See Zizzo and Oswald (2001). On that also, see Burnham (2003) (he ran an experiment measuring the testosterone levels in economic exchange).

Serotonin and pecking order:
Frank (1999) includes a discussion.

On the social role of the psychopath:
See Horrobin (2002). While it may have some extreme views on the point, the book reviews discussions of the theories around the success realized by the psychopaths. Also, see Carter (1999) for a presentation of the advantage some people have in being separated from the feeling of empathy and compassion.

Social emotions:
Damasio (2003): “One of the many reasons why people become leaders and others followers, why so many command respect, has little to do with knowledge or skills and a lot to do with how some physical traits and the manner of a given individual promote certain emotional responses in others.”

Literature on emotions:
For a review of the current scientific ideas, see the excellent compact Evans (2002). Evans belongs to the new breed of the philosopher/essayist contemplating large themes with a scientific mind. Elster (1998) goes into the broad social implications of emotions. The bestselling Goleman (1995) offers a surprisingly complete account (the fact that it is a bestseller is surprising: We are aware of our irrationality but it does not seem to help).

CHAPTER 2

Possible worlds:
Kripke (1980).

Many worlds:
See the excellently written Deutsch (1997). I also suggest a visit to the author’s rich website. The earlier primary work can be found in DeWitt and Graham (1973), which contains Hugh Everett’s original paper.

Economics of uncertainty and possible states of nature:
See Debreu (1959). For a presentation of lattice state-space methods in mathematical finance, see Ingersoll (1987) (well structured though dry and very, very boring, like the personality of its author), and the more jargon-laden Huang and Litzenberger (1988). For an economics-oriented presentation, see Hirshleifer and Riley (1992).

For the works of Shiller:
See Shiller (2000). The more technical work is in the (originally) controversial Shiller (1981). See also Shiller (1990). For a compilation: Shiller (1989). See also Kurz (1997) for a discussion of endogenous uncertainty.

Risk and emotions:
Given the growing recent interest in the emotional role in behavior, there has been a growing literature on the role of emotions in both risk bearing and risk avoidance: The “risk as feeling” theory: See Loewenstein, Weber, Hsee and Welch (2001), and Slovic, Finucane, Peters and MacGregor (2003a). For a survey, see Slovic, Finucane, Peters and MacGregor (2003b). See also Slovic (1987).

For a discussion of the affect heuristic:
See Finucane, Alhakami, Slovic and Johnson (2000).

Emotions and cognition:
For the effect of emotions on cognition, see LeDoux (2002).

Availability heuristic (how easily things come to mind):
Tversky and Kahneman (1973).

Real incidence of catastrophes:
For an insightful discussion, see Albouy (2002).

On sayings and proverbs:
Psychologists have long examined the gullibility of people in social settings facing well-sounding proverbs. For instance, experiments since the 1960s have been made where people are asked whether they believed that a proverb is right, while another cohort is presented the opposite meaning. For a presentation of the hilarious results, see Myers (2002).

Epiphenomena:
See the beautiful Wegner (2002).

CHAPTER 3

Keynes:
Keynes’
Treatise on Probability
(Keynes, 1989, 1920) remains in many people’s opinion the most important single work on the subject—particularly considering Keynes’ youth at the time of composition (it was published years after he finished it). In it he develops the critical notion of subjective probability.

Les gommes:
Robbe-Grillet (1985).

Pseudoscientific historicism:
For an example, I suggest Fukuyama (1992).

Fears built into our genes:
This is not strictly true—genetic traits need to be culturally activated. We are wired for some fears, such as fears of snakes, but monkeys who have never seen a snake do not have it. They need the sight of the fear in the facial features of another monkey to start getting scared (LeDoux, 1998).

Amnesia and risk avoidance:
Damasio (2000) presents the case of David the amnesic patient who knew to avoid those who abused him. See also Lewis, Amini and Lannon (2000). Their book presents a pedagogic discussion of “camouflaged learning,” in the form of implicit memory, as opposed to explicit memory (neocortical). The book portrays memory as a correlation in neuron connectivity rather than some CD-style recording—which explains the revisions of memory by people after events.

Why don’t we learn from our past history?:
Two strains of literature. (1) The recent “stranger to ourselves” line of research in psychology (Wilson 2002). (2) The literature on “immune neglect,” Wilson, Meyers and Gilbert (2001) and Wilson, Gilbert and Centerbar (2003). Literally, people don’t learn from their past reactions to good and bad things.

Literature on bubbles:
There is a long tradition, see Kindleberger (2001), MacKay (2002), Galbraith (1991), Chancellor (1999), and of course Shiller (2000). Shiller with a little work may be convinced to do a second edition.

Long-term capital management:
See Lowenstein (2000).

Stress and randomness:
Sapolsky (1998) is a popular, sometimes hilarious presentation. The author specializes among other things on the effect of glucocorticoids released at times of stress on the atrophy of the hycocampus, hampering the formation of new memory and brain plasticity. More technical, Sapolsky (2003).

Brain asymmetries with gains/losses:
See Gehring and Willoughby (2002). See the works of Davidson on the anterior brain asymmetry (a clear summary and popular presentation in Goleman 2003). See also Shizgal (1999).

The dentist and prospect theory:
Kahneman and Tversky (1979). In this seminal discussion they present agents as interested in differences and resetting their pain/pleasure level at zero as “anchor.” The gist of it is that “wealth” does not matter, almost only differences in wealth, since the resetting cancels the effect of the accumulation. Think of John hitting wealth of $1 million from below or above and the impact on his well-being. The difference between utility of wealth and utility of changes in wealth is not trivial: It leads to dependence on the observation period. In fact the notion, taken to its limit, leads to the complete revision of economic theory: Neoclassical economics will no longer be useful beyond mathematical exercises. There have been vigorous such discussions in the hedonistic literature as well: See Kahneman, Diener and Schwarz (1999).

CHAPTER 4

Public and scientific intellectual:
Brockman (1995) offers presentations by the “who’s who” in the new scientific intellectual tradition. See also his website,
www.edge.org
. For a physicist’s position on the culture wars, Weinberg (2001). For a presentation of a public intellectual, see Posner (2002). Note that Florida Atlantic University offers a Ph.D. to become a public intellectual—literary, since scientists need no such artifice.